Inflation has become the paramount concern of developed economies across the world. Whilst governments directed their attention towards managing sluggish growth and rising unemployment amidst the pandemic, inflation was only a secondary concern. Now, countries like the USA and Australia are recognising the long-term implications of their decisions, causing them to adjust monetary policy as they look towards a contractionary future. In last week’s article, we briefly discussed the burgeoning level of inflation in Australia. This week, we are going to analyse the true extent of price stability in Australia at the moment, as well as the complicated relationship between inflation, interest rates and exchange rate stability.
The inflation problem and how the RBA intends to address it
The ABS reported that the Consumer Price Index (CPI) for all groups across Australia rose by 1.3% in the December quarter of 2021. To put it simply, the CPI is a measure of price based on a weighted average of goods and services that households purchase in Australia. The 1.3% CPI increase is a slap in the face for Australia - a country that saw an average CPI increase of 0.73% in the previous three quarters of 2021.
As the price of consumer goods surges and the unemployment rate falls to a low of 4.2%, Phillip Lowe has been forced to reconsider the future of monetary policy in Australia. After the RBA kept the 0.10% cash rate on hold this week, Phillip Lowe stated in a recent speech that “interest rates will go up”, hinting at a potential interest rate hike in the near future. This statement is reminiscent of the Federal Reserve’s speech two weeks ago, where they stated it “would soon be appropriate to raise the target range for the federal funds rate”.
The Federal Reserve and the RBA both noted that inflation rates are above-target and the labour market is stronger than ever, with unemployment at a low for both the US and Australia. Hence, Phillip Lowe’s announcement came as no surprise.
Higher interest rates have the potential of causing serious damage to Australian households, sending them into sheer pandemonium as the cost of borrowing rises and mortgages become unpayable. As noted by the aforementioned Yahoo article, it has been more than 11 years since the RBA increased the cash rate, with the last increase being a response to strong post-GFC economic growth. And as Sally Tindall from RateCity notes, there are more than 1.1 million households in Australia that haven’t experienced an interest rate hike since purchasing their home(s).
When the cash rate rises, banks respond by increasing their own interest rates in order to preserve their profit margins. As a result, it becomes more expensive for households to borrow money from lenders (i.e. banks), increasing the value of mortgage repayments for Australian households. For new homeowners with limited funds and minimal ‘buffers’, the impending interest rate hike could limit their ability to afford their mortgage repayments, hollowing out the housing market for a whole new generation of homeowners. This potential implication has made the RBA reluctant to raise interest rates, in fear of ‘what happens next’ to homeowners.
How are inflation and interest rates linked to a nation’s exchange rate?
Typically, when interest rates are expected to rise, the exchange rate suffers from a short-term depreciation as investors begin to sell in the hopes of higher future returns on investment. Once interest rates are finally tightened, Australia should expect an appreciation of its dollar, as investors favour Australia’s positive interest rate differential and seek higher returns on investment.
However, the issue for Australian investors is determining when interest rates will actually rise. The RBA stated that wage growth, also known as Wage Price Index growth, is expected to accelerate to 3% by the end of 2023. This expectation is impairing the RBA’s decision making and is hindering their ability to raise interest rates in the near future, as Lowe aims to keep wage growth consistent with the inflation rate - a rate that is outpacing wage growth in early 2022.
As such, economist Warren Hogan argues that it is likely that the US Reserve Bank will tighten interest rates before the RBA decides to, worsening Australia’s interest rate differential and limiting demand for the AUD. Hogan believes that this could lead the exchange rate to “break below US70¢ over the first half of 2022”. Hogan’s prediction came into fruition at the end of January 2022, when the Australian currency briefly hit a low of US69.68¢.
The Federal Reserve’s unusual behaviour has already caused exchange rate volatility for the US exchange rate, with the USD falling from 0.89 to 0.87 Euro on the 3rd of February, only a day after several Federal Reserve presidents spoke about increasing interest rates. It is highly likely that the Australian Dollar will experience similar short-term volatility as citizens patiently wait for Phillip Lowe to make his next move.